European banks to face tougher stress tests in 2018

Logo of the European Banking Authority.

Some 48 institutions representing 70 per cent of European banking sector assets will be put through their paces in the exercise, conducted with technical assistance from the eurozone's top supervisor, the European Central Bank (ECB).

Financial firms will be trialled on four different types of risks that regulators have identified as the most dangerous to financial stability in Europe.

The biggest risk is a so-called "confidence shock", a speculative scenario that could see major political uncertainty push financial market investors to sharply increase the "risk premium" they demand when lending money.

Other tests will probe the impact of renewed doubts about government and corporate debt sustainability and the risks to the whole financial sector from a shortage of liquidity in the "non-bank" financial world of investment firms, insurance companies and others.

In the worst-case simulation, the EBA will work out the effects of a two-year recession in the EU, with the economy shrinking by 1.2 per cent in 2018 and 2.2 per cent in 2019, followed by mild growth of 0.7 per cent in 2020.

Aside from economic decline, it would simulate a 3.3-percentage point increase in unemployment, from 8.7 per cent last November, and a 28-per cent fall in property prices by 2020.

The EU economy would end up 8.3 per cent smaller under such conditions than it is forecast to be on current trends, making the test the harshest carried out yet, officials said.

Economic risks linked to Britain's departure from the EU, such as falling trade across the English Channel, have been included in the tests.

After the third round of stress tests since 2014, results will be released in November, rather than in July as happened during the last round in 2016.

EBA officials agreed to banks' request for more time, which they said they needed to wrap their heads around new accounting rules known as IFRS 9 introduced in January.

The updated guidelines are designed to make losses appear more quickly on lenders' balance sheets.

Banks will not have to meet any specific capital requirements to pass the tests, but the results will be used by the ECB to judge the capital needs of lenders under its supervision.